Fixing Egypt's Subsidy Nightmare

With gas at $1.73 a gallon, no wonder Cairo’s traffic is a nightmare. And with bread at less than a cent apiece, it’s no surprise that the city’s sidewalks are lined with discarded pitas. By using subsidies, governments in the Middle East and North Africa ensure that everyone, including the poorest, have access to basic consumer goods at an affordable price. But energy and commodity subsidies are becoming an increasingly heavy drain on public resources, while bringing only very small benefits to those in need.

In Egypt, the middle classes, the well-off and big business are the biggest beneficiaries of the subsidy system. A typical better-off Egyptian receives roughly twice the amount in subsidies as a genuinely poor one. At the same time, subsidies to fuels and food account for almost one-third of the total government budget, or over 10 percent of the country’s GDP. Thus the subsidy issue is the key to solving Egypt’s public-finance problems.

Yet reform is a daunting task. For Egyptians, subsidized commodities are an essential part of the perceived social contract between the citizens and the state. Egyptians have traditionally had little say in public affairs and could never expect much from their government (other than taxes, onerous bureaucracy and a constant hassle). When President Sadat attempted to cut bread subsidies in 1977, violent nationwide riots ensued. The same thing happened thirty years later, following a hike in food prices in 2008.

So far, attempts to address the subsidy problem have been shambolic. In October 2012, Prime Minister Hisham Kandil announced that the government was planning a gradual reform of energy subsidies. The proposal suggests setting a cap on how much cheap fuel and cooking gas each household can purchase, with each Egyptian household to have access to only two cylinders of fully subsidized butane (used for cooking); further consumption would be subsidized only partially to discourage pervasive leakage to the black market.

The proposed reform helps address one of the problems: subsidized commodities are available to everyone, regardless of their income or wealth. Wealthier Egyptians buy more cooking gas, gasoline or electricity than poorer ones. Thus the bulk of the spending on subsidies ends up benefiting the rich.

At the same time, a cap on purchases won’t solve the deeper problem with subsidies. As anyone who has received an unwanted yet expensive Christmas present from a distant uncle can attest, transfers of commodities are a clumsy way of making people better off. “If only he gave me cash!” tends to be a common reaction, especially when the gift comes without a return receipt.

Similarly, receiving cheap commodities instead of cash, Egyptians often end up with an abundance of goods they either don’t need or don’t value much, resulting in waste and black markets. Imposing a cap or trying to direct the subsidies at poorer families does not change the fact that it is much cheaper to help people by giving them money than by handing out stuff.

Egyptian policymakers need to study other countries that tried to deal with the subsidy problem in the past. In the 1990s, various Arab countries, including Jordan, Yemen, and Tunisia, reformed their food-subsidy programs. Jordan started by first limiting the availability of ration coupons to low-income groups and then by gradually replacing them with cash transfers. By 1999, food subsidies had been replaced by payments from the National Aid Fund.

Policymakers in Yemen followed a similar route and brought down a food-subsidy budget that accounted for 7 percent of GDP in 1996 to zero within three years. However, targeting cash at needy people has proven to be much more difficult than in Jordan, which may explain the return of the subsidy problem in the 2000s.

Finally, Tunisians tried something different. Instead of replacing subsidies with cash transfers, they eliminated subsidies on higher-quality goods that were consumed mostly by the middle classes and the rich, while keeping subsidies on inferior products bought mostly by poor people.

The best option is to simply turn the subsidy system into a temporary stream of unconditional cash transfers to every Egyptian, eliminating the distortions of in-kind redistribution, such as the bloated network of various middlemen, licensed bakers, gas distributors and flour dealers. That has the potential to demonstrate the benefits of cash redistribution and create a wide constituency for future reforms.

Egypt finds itself in a tough place. The military has a firm hold on power. The radical Islamists are challenging the Muslim Brotherhood’s dominance in the political arena. The country is in a state of latent civil unrest. It is no wonder few Egyptian politicians are willing to entertain radical reform. Yet that is exactly what is needed to get the Egyptian economy back on track.

Making subsidy reforms popular will require compensating the losers—not only the poorest segments of the population. After all, the poorest are not necessarily the ones who are most likely to show up in Tahrir Square. While broad compensation would limit immediate fiscal gains from reform, it could be executed rapidly, without first instituting a complex system of means testing.

Very often, economists advising governments recommend carefully timed and gradual reforms, since they create few painful dislocations in the economy. But such an approach ignores the political reality of the country. A plan by Egypt’s government that extends over many years will not be seen as credible if the government has only a tenuous political mandate and faces deep domestic divisions.